The Credit Write-Up Again (Session #8)
Q: In your actual industry experience, how likely is it for someone like Larry Crevin to accept such restrictive covenants?
A: The likelihood depends on the competitive environment and the leverage of the client. If the client is easily bankable, the lender has little leverage in imposing restrictive covenants of any nature. But if the client is a marginally bankable company, the lender's leverage increases considerably – especially if the competition for the client's business is weak to non-existent.
The general economic environment will have an impact, too. If expectations of a pending slowdown or recession are widespread, the lender's leverage and ability to impose more restrictive covenants increases, simply because lenders will take every measure possible to protect their position should a downturn or recession emerge.
Q: On Slide 30, the Adjusted SG&A should still be different though, because of the distributions required to pay taxes.
A: We adjust SG&A only by the amount of distributions that represent compensation. Because distributions and loans will be limited to the income tax obligation only, projected SG&A will have no additional compensation, and so the “adjusted” SG&A will be the same as the unadjusted SG&A, because no adjustment for additional compensation will take place.
The amount of distributions attributed to income taxes is accounted for at the end of the income statement where we would arrive at a Profit after Taxes amount.
Q: On Slide 57 you mentioned that they couldn't cover debt service, but on Slide 49 it looks like the DSC for 2014 is 1.48.
A: On Slide 57 we set forth risks to the primary, secondary, and tertiary sources of repayment. One of the risks to the primary source of repayment is excess owner compensation.
The Business Profit Coverage of 1.48 on Slide 49 is a simple relationship to show whether the company could meet its debt service from projected Business Profit. It is not offered as a debt service coverage ratio that we use as a covenant in the loan agreement.
Slide 58 provides a suggested DSC of 1.25 as a mitigant to the risk of excess owner compensation. If we define this DSC as Business Profit Coverage, then the projected 1.48 would exceed this requirement if the projections hold up.